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eldavojohn writes "Oh if only we could identify the bubble markets as they appear, but with all the random variables, it would take some sort of econophysicist to build predictions for that! Well, a team has released a definition of a 'bubble index' that led them to make predictions of bubbles six months ago that would pop between then and now. The four bubbles they selected were the IBOVESPA Index of 50 Brazilian stocks, a Merrill Lynch Corporate Bond Index, the spot price of gold, and cotton futures. Two out of the four were bubbles, with Merrill Lynch being a bubble already popping and cotton continuing to soar into even bubblier status. Still, for your first try, 50% isn't bad. The team learned a lot of new things from the first run, revised their method, selected their predictions for the next six months, and sealed them. Only time will tell if they are truly onto predicting crashes."

Right, it's like traffic: if you alert everyone to a blockage somewhere, and everyone reroutes to avoid it, then the alternative routes will get clogged and the original slowed route will now be empty.

Right, it's like traffic: if you alert everyone to a blockage somewhere, and everyone reroutes to avoid it, then the alternative routes will get clogged and the original slowed route will now be empty.

That's exactly what you observe on a freeway. There's a merge coming up in the left lane (Australian here, all you backwards U.S. citizens just pretend I'm ambi-dyslexic:P ) so everyone dives into the rightmost lane, which comes to a stop. The fastest way to get through that section of road is to stay in the leftmost lane until the left and middle lanes merge, then try and find a gap in the right lane where some dozy bastard doesn't keep up with traffic. That way you skip the congestion and get into the right lane just as it frees up.

Everybody is giving you shit about being an asshole, which can be the impression seen from the drivers who just sat in the long line, but research in traffic has shown that this is exactly the most efficient way to navigate such a condition. Unfortunately, it requires alert drivers, so it doesn't apply to most humans.

I've always found it annoying that everyone slows down at bottlenecks. Bernoulli would recommend that we all speed up to keep the traffic from snarling.;)

Oh? Why? It's not my fault that the bozo in the right lane is messing with his phone and leaves a 20m gap in front of him, while everyone behind him is stationary. By using space on the road that's otherwise empty, and doing so in a safe manner, (it's not like I'm forcing my way through or making anyone else slow down) I'm choosing to be part of the solution, rather than part of the problem.

I'm guessing either you're one of those timid drivers who has to sit in a traffic queue and cuss at everyone else be

The key to the efficient market hypothesis is universal knowledge. Everybody must know everything, reality does not conform.

The GP's point was that the bubble index would be "universal knowledge" and thus could not be exploited for advantage, in the spirit of the Efficient Markets Hypothesis. IANAE and I'm not trying to defend the hypothesis. I'm just saying it's not new.

In terms of investing? No, none at all. In the same vein as one man's terrorist is another man's freedom fighter, one man's tool to gain a market advantage is another man's tool to prevent catastrophe.

PS: Yeah, the Efficient Market Hypothesis rules. No system can ever beat the stock market even if we ignore the random events which can totally destroy any system (eg. wars, accidents, BP oil spills, etc.)

Psychohistory (Asimov's Foundation series) suffers the same flaw. The key was to have a small group hold the answers, and guide/warn when appropriate.
The trouble then becomes selecting a group that we can trust with the wealth of nations, and the power to destroy by proclamation.
I don't trust any group with that much power not to grow corrupt. Best that this secret be out and become useless.

Of course. Any kind of long-term planning with actual facts and the ability to make predictions based on those facts is evil. Best leave it in the hands of a small group of people without the necessary predictive abilities, no incentive at all towards ensuring long-term stability and a strong incentive towards petty short-term power grabs - otherwise known as a democratically elected government. It appears that people detest not being in the loop far more than any economic/political disaster.

But they don't want the bubble to happen, that's the point.
By being able to predict that bubbles are happening, the markets can sell off sooner, rather than allowing the bubble to continue growing, and thus once the sell-off happens, it is not such a dramatic down-shift, since the prices were not allowed to rise to artificial highs.

The point is to not allow the bubble to happen in the first place, not to be the first to predict the bubble crashing. If the bubble can be prevented, then panic selling won't happen.
When the market bubbles, and then crashes, it doesn't go to an artificial low, it just drops the the point at which steady growth would have taken it. By predicting possible bubbles and preventing them, you should be able to get steadier growth.

If the low is artificial, does that mean that the high is artificial? Also, what do you mean by artificial? When I see words like that in conjunction with a problem (e.g. bubbles), I tend to think that the solution is to get rid of whatever artificial factor there is, not pile more countermeasures against it (such as this index). There are many schools of thought on this issue.

10 other people look at what the company is doing with that $1M and think it's a good idea and would be worth lots more so they start saying I'll pay $1.01 a share, $1.02 a share, $1.10 a share...etc until people start selling it. 100 more people see it start going up so they think there must be something going on and say I'll pay $1.20 a share, $1.30 a share, $2.03 a share etc... This is the time of the bubble when people that don't really do any investigation into the market but buy simply because it is going up. At some point there will be some more savoy investors come by and see that the stock is far to high and short sell a stock. A way of borrowing stock at a higher price then getting the difference when you return it at a lower price (or paying the diff if it goes up.) Eventually it'll come out that this company has only been able to turn the $1M into a $1.2M company and not the $2M+ that the market cap has it at and people will start to sell off. This is when the bubble pops.

There are other artificial things that can cause bubbles than just perceived value, like the government backed mortgages causing the real estate bubble.

Won't work. Pretty much anybody with any brains knew the housing thing was a bubble but nobody wants to pull out of a bubble before it peaks. Imagine if you pull out and have to sit and watch everybody else make money if the bubble lasts another year.

Bubbles last as long as no big players get too nervous and I'd like to know how software can predict that effect.

Won't work. Pretty much anybody with any brains knew the housing thing was a bubble but nobody wants to pull out of a bubble before it peaks. Imagine if you pull out and have to sit and watch everybody else make money if the bubble lasts another year.

Most people don't have brains (or the necessary mental tools, anyway), and that can make things unpredictable. Even those with planet-sized brains can't predict the outcome when it's at the mercy of the brainless masses. All bubbles may burst, but not necessarily in your lifetime.

Besides, even fairly sensible people get scared. No-one thinks 'one day, I too will own Microsoft shares', but people DO think that about houses. When you see prices going up and up you can start to worry that you'll be locked o

But they don't want the bubble to happen, that's the point. By being able to predict that bubbles are happening, the markets can sell off sooner, rather than allowing the bubble to continue growing, and thus once the sell-off happens, it is not such a dramatic down-shift, since the prices were not allowed to rise to artificial highs.

Which, of course, will assure everyone that it can't possibly be a bubble, allowing them to comfortably jump back into the asset.

Stability breeds instability. This will only result in larger bubbles. Never match wits with mass stupidity when money is on the line.

1) Hand out hockey sticks.
2) Wait for someone with a graph and utters the words "like a hockey stick" when describing said graph (usually while wildly gesturing and telling you why X is such a good investment, why you should stick with the company, or why "it is different, this time").
3) Beat that person with the stick from step 1.
4) Sorry, no profit, but less pain; Widows and orphans are spared... At the very least it is good cardio and even if you are jailed, you get free room and board.

And so eventually, everyone will feel safe if this predicts it's not a bubble. And they will keep buying, because the algorithm says it's not a bubble. Then finally someone will realize the underlying asset isn't really worth that much and the bubble will pop. Which is kind of what happened in the real estate bubble.....everyone thought real estate wouldn't have a bubble, and then finally it popped (actually that's not entirely true, a lot of people thought it was having a bubble many years before it popp

That is just simple minded to think we do not want bubbles. We have known since the 1980's that the current path is unsustainable, but was designed to be only transitionary (aka sustain the post industrials until asia's gdp per cap improves). It was thought that the 1990's recession would be the end of the major economic cycle, but the tech bubble and 2000's re-estate bubble slowed the inevitable to this point. It appears we will not be so lucky this time...

In short... It is very easy to see a bubble, and most of us knew exactly what it was. However, to pretend that you want to predict bubbles pretends that you have sustainable system. The current system is not...

...and the method will be criticized because it failed to predict a bubble correctly. Predicting the outcome of a decision that takes the prediction into account is in many cases (not all) an undecidable problem.

There's an old saying that the market will never be figured out, because as soon as we do, it will suddenly get more complicated because of that. This is pretty much what you are saying.

I'd also like to point out that a 50% success rate isn't really that good when you are picking scenarios that are already likely to be bubbles anyway. In fact it's rather bad. But good they are learning things.

Except that they won't, for two reasons:1. Investors are (collectively at least) really stupid. This has been proven time and again.2. They think "this time, it's different. We know how to prevent this from becoming a bubble."

For instance, there were smart economists saying back in 2006 or so "watch out, there's a housing bubble". And what most of Wall St did was say "shut up, I'm busy counting my winnings".

Unless the investors were super smart and realized they could create a housing bubble, make billions during it, then when it bursts beg uncle sam for billions more and end up with "collateral winners", i.e. people who "inadvertently" benefit from our tax money while 1 and 10 of those of us who paid for it are laid off.

In truth, identifying bubbles is actually remarkably easy. Famed investor Jeremy Grantham defines a bubble as a "3-sigma" event - that is, times when some fundamental ratio of value (such as P/E ratios, price-to-income ratios for housing affordability, price-to-rent ratios, etc.) - is more that 3 standard deviations above the mean for that ratio. Importantly, he showed that of 30-some odd historical bubbles, they ALWAYS popped, ALWAYS giving up more than 100% of the gains during the bubble period.

What is difficult, though, is trying to figure out WHEN a bubble will pop. The Nasdaq was far overvalued in mid 99 - that still didn't prevent it from DOUBLING in early 2000 before it burst.

Grantham also makes a good case as to why bubbles form. Tons of people in the financial world saw that risk was being underpriced in 2006/07. However, what would have happened if a CEO of a major bank would have said back in late 2005 / early 2006 "This is crazy, we're not going be backing these loans given to anyone who can fog a mirror"? That bank would have seriously underperformed its peers for the next two years, and that CEO would have been ousted long before his prudence would have been proven correct.

On the other hand, one of the problem is that bubbles look very much like booms on the way up. So sure, back out of anything growing rapidly and you're almost certain to avoid all bubbles. You're also going to miss out on a ton of profit when it's not a bubble. Not to mention everybody thinks they're smarter than everyone else and will back out when it starts losing money. That is why the stock market crashes, it's not a stable system. Suddenly you pass some sort of critical threshold of people leaving and

Identifying things that WERE bubbles is easy enough, depending on what you define a bubble to be. Inside a bubble, the intrinsic defining feature of a bubble is that it is NOT observable, or else everyone would make a fortune off those not observing it by predicting it and drive the price down to prevent it from ever actually being a "bubble". If you are capable of observing a bubble, then by definition you are NOT capable of stopping it.

Here's a smart economist saying an economist's saying: 12 out of the last 5 market crashes have been predicted. Half the people in the market (also known as "sellers") think the market is going down, and half the people (also known as "buyers") think the market is going up. Both have monetary incentives to proclaim the forthcoming terror/utopia and every day the economic and business news is full of them. They aren't listened to for a reason.

A few other thoughts along those lines: Warren Buffet said, "In the
short run the market is a voting machine, in the long run it's a weighing machine".

What's interesting about that comment is that he never said what it weighs.
People usually infer that it's the value of the company, since Buffet is a value
investor. OTOH, the market might really be weighing a number of other things.
It might be weighing how much money you have in the first place, since the rich
can afford better equipment and advice. It might be weighing the ping time from
your office to the exchange, as we've seen with high-frequency traders. It might
actually be weighing your skills, and that last one leads to something else.

Let's say, for the sake of argument, that skillful players really can beat
the market. Furthermore, let's say that the top 1 % win and the bottom 99
slowly lose. We would expect the 99 to drop out of the market if they were rational.
Therein is a fundamental flaw with economics. It assumes people are rational.
This is Greenspan's self professed mistake, although IMHO he also failed to realize
that firms aren't people and that the people who ran firms into the ground were
behaving rationally with respect to their own self-interest (greed). The people who "believed",
CEOs, contrary to numbers, were less rational.

So the way I see it, bubbles will continue for the same reason Las Vegas
exists. People aren't rational, and nobody really knows where the wheel
will be until we OBSERVE that it has stopped spinning.

Let's say, for the sake of argument, that skillful players really can beat the market. Furthermore, let's say that the top 1 % win and the bottom 99 slowly lose. We would expect the 99 to drop out of the market if they were rational.

Which is why speculators prefer to operate in dark markets. For the 1% to make money reliably, they need the 99% to keep trading. The 99% actually don't lose outright. They just don't make as much. As long as they can't see the entire game, they think they're dong OK and keep playing.

Except the system chose 4 out of all the other possibilities. Maybe if we knew how many of all the possibilities showed themselves out to be bubbles. If it was none, then it would be possible to say that it accurately guessed 98/100 or whatever the number of total different markets are.

Let's face it, if it has "econo" anywhere in the name of the discipline, it's about 2 levels softer than sociology.

I work in the physical sciences but I think you're being too harsh on economics here, especially with the statement I quoted above. Economics has little predictive power (I believe it's getting there, but that's debatable). What people don't give it enough credit for is its explanatory power (or postdiction if you will). I think its predictive problems arise simply because of the sheer size and level of connectedness of the global economy and the relatively high (effective) free will of its major players.

That's the advice economists have been giving us! But the Fed in the 90s thought home ownership was more important, and kept rates low. Now that there was a recession, they didn't have much to manipulate without hitting zero (which they did).

The post-WWII US economy was good because the rest of the developed world had blown its industrial infrastructure to bits. Any other reason you hypothesize, even if correct, is insignificant in comparison to this overwhelming factor.

... in the years after the 2nd world war we used to treat every wild upswing as a bubble and increase the interest rates. Every downturn got a reduction in rates.

It was the same kind of negative feedback that engineers use to prevent oscillation (feedback squeals, for example).

You'll notice it worked. The converse worked much less well.

--dave

Interesting. I like the analogy with negative feedback because there too, you don't need to know in detail what the system will do, so long as you have the ability to affect it. Delving into that analogy though (and I use a PID controller daily and have seen what can fuck up the feedback), you need fast response (before the situation goes so far out of control that your ability to affect the system ceases to be powerful enough to bring it back into lock). You also need to have some idea of what the system w

You can make an entirely general statement about the Americas and Europe in the 1950s and 60s, when this was a general policy. That's the "we" in question, not any particular individual. As to the definition of "worked", a lack of significant bubbles and lows over a significant period, as compared to the years afterward when the policy changed will do the job.

As to the definition of "worked", a lack of significant bubbles and lows over a significant period, as compared to the years afterward when the policy changed will do the job.

It will do the job just as soon as you prove that nothing else could possibly be responsible, and further, that the same strategy would have worked here. Not saying it wouldn't, just saying it's not proven.

US firms where rebuilding the world, US interests where protected by a fear of the Soviets. The production lines ran fast and the world imported by need or fear.
Things where 'good' for the US as the market had room to expand worldwide.

Exactly how are they claiming success? Over the past 6 months (their claimed timeframe), gold (or the very close proxy, GLD), is up a bit vs. the Dow and S&P 500, and down a bit vs. NASDAQ. That's hardly a popped bubble.

I thought the same thing at first, but that would only be true if they'd looked at four samples and picked winners and losers from there. What they actually did was look at a number of items (the value of N here isn't clear to me) and picked four which they thought were bubbling. 50% of those predictions were correct.

It depends on what you're predicting 50% of. If you predict 50% of the winners of a horse race, then half the time you're choosing the right horse. You could probably make a living at the track. On the other hand, if you predict 0% of the winners, you'll go broke betting on the other 9 horses all the time.

Yeah, the US is firing up the printing presses and borrowing the value of all the gold in Fort Knox every few months. Gold must be in a bubble. The algos told me. Paper dollars backed by Ben Bernanke's good looks are better than the one thing that has functioned as currency throughout human civilization. The econophysicists have helped the financial elite and the central bankers create a rigged, casino-style market that systematically steals from the middle class, and you're congratulating them for gambling

Having a new model/metric to play with is nice. But, it wouldn't have made a damn bit of difference with the most recently departed "phantom value". The core issue is that when people are making a lot of money off a hot economic streak, rich people in particular, there's a strong incentive to not screw with the gravy train. Hell, The Economist, for one, had spent three or four years publishing charts and stories suggesting that the western European/North American real estate bubble was unsustainable, and due for correction.

The missing bit of information was exactly what the corrective signal was going to be. The US Federal Reserve - in the person of Mr. Greenspan - could have provided it, but the Fed board is full of conservative bankers that didn't want to rock the GOP's boat. The various Wall Street bankers could have provided it, but instead they were busy putting out increasingly meta-physical financial products to squeeze another round of bonuses out of the market. So instead, they were all Cosmo Kramer, joy-riding the Saab down the expressway for as long as the fumes kept it going.

It doesn't matter what predictive tool you've got, even the Word of the Lord wasn't and isn't going to stop people from trying to grab that extra [your monetary goal here], if there's any money left on the table.

What was the criteria for evaluating success? TFA says that the impressive result by anyone's standards is that they predicted a crash in gold, which then was roughly flat for the next six months...
There is an entire industry of "quants" attempting to do things like this for banks and hedge funds. Of course, they do not publish their results. If you would like to see what a good classification of bubbles looks like, see: http://dealbook.blogs.nytimes.com/2010/01/27/schillers-list-how-to-diagnose-the-nex [nytimes.com]

Having read the paper, this is more ridiculous than I initially suspected. Of the four assets that they identified as being "bubbles", all four increased in price since they made the prediction! The only way to ultimately determine if a bubble is a bubble and not a rational increase in prices is by the subsequent collapse. They try to hedge themselves by saying that it changed into "some other sort of regime", ie non-hyper-exponential growth. So if it is flat, or down, or up they are correct. The only instance they claim to be able to predict is that the asset will not increase hyperexponentially. And they even fail at this, in the price of cotton. Sadly, can claim some knowledge in the realm of finance.

So, suppose this "methodology" is used to predict a bubble in a particular industry. Suppose that it is wrong. It will still trigger a huge selloff. Suppose, again, that someone using this "methodology" is motivated by personal gain (turns out economists are human, too. Who knew?). Buy low, sell high, as the old adage goes. Well, how better to buy low than to trigger a massive selloff, then swoop in and buy, buy, buy when there is no actual bubble.

All the market bubbles in the lifetimes of everyone alive to read this post have been noticed as they arrived, and usually foreseen. Indeed, most of them have been created, to be exploited.

The problem is deflating the bubble before it pops. While we probably know how to do that, doing so fails to make those who see and create them as rich as just letting "nature" take its course. And those people are in charge.

Trying to fix "no one could have anticipated X would catastrophically fail" is just further suppor

That is 50% for false positives, but how about false negatives? Are those just not to be factored in with the effectiveness of this technique? One should also be able to identify markets that were tested and then not identified as bubbles and later burst.

"Econophysics is an interdisciplinary research field, applying theories and methods originally developed by physicists in order to solve problems in economics, usually those including uncertainty or stochastic processes and nonlinear dynamics."

Guys , news for you : it does not matter that you are using physical models. You are NOT physicist. YOu are mathematician. If the model came from biology instead you would not be an econobiologist. The equation and model you are using MAY come from physic, but if y

Econophysics is an interdisciplinary research field, applying theories and methods originally developed by physicists in order to solve problems in economics,

Could be interesting - no physicist would believe that something could grow exponentially for ever without hitting some limit or exhausting some resource, yet that seems to be an article of faith for the economy.

OTOH, if they start applying quantum mechanics to the economy, run for the hills... Structured Investments and CDOs were nuffin'!

Apparently, even financial geniuses can miss bubbles -- see here [forbes.com], for example.

Not to say anything against the financial geniuses of the world, but if even objectively successful investors can miss something as huge as the U.S. housing bubble, it just reinforces my suspicion that those financial types are merely experts on the small scale, and ignorant of the big picture.

The big picture being: population grows. Places where you can find gainful employment are growing at a lesser pace because of limited n

I'm on record [downside.com] as having called the dot-com bubble, the oil spike, and the mortgage crisis. It's not hard to predict bubbles. If you look at historical ratios, it's usually clear when assets are overpriced. Historically, the median house in the US sells for 2x to 2.5x the median income. That's about what people can pay for. That ratio hit 4 nationally, and 10 in some states. It was blindingly obvious that there was a housing bubble.

Dot-com predictions were easy. I had a program which read SEC filings for cash and burn rate, and simply projected when the money would run out. This was far more successful [downside.com] than one would expect. I used to get hate mail from CFOs for that.

The problem is figuring out when a bubble will pop. I expected the mortgage bubble to pop about two years earlier than it did. (Arguably, the Fed's cheap-money policy under Greenspan postponed the inevitable.)

Predictions on the debt side are harder than on the equity side. Public policy dominates the debt world. I don't make political predictions, so I can't say much about the current situation. I've been expecting an interest rate spike for years, but instead we've had a Federal deficit spike as money is pumped into the system. Eventually something will give there, as with Iceland, Greece, and other debtor countries. I'm not sure how that will unwind. We may get an interest rate spike and hyperinflation, which is what usually happens when a currency gets into trouble.

50% is also known as a completely meaningless prediction. Basically, it says the price could go up or down.

Bubbles are theoretically impossible to predict. If there existed any convincing predictable evidence that an asset price was a bubble, then everyone would sell the asset by the point it crosses that threshold, meaning the price would have gone down, contradicting the predicate that it was a bubble.

"Bubbles" are nothing more than post-hoc descriptions of prices that went up and came down, just like "ba

I'd rather predict 0%. That way I could reverse the predictions and get100%. 50% means a flip of a coin would work.

It depends on what you're predicting 50% of. If you predict 50% of the winners of a horse race, then half the time you're choosing the right horse. You could probably make a living at the track. On the other hand, if you predict 0% of the winners, you'll go broke betting on the other 9 horses all the time.

Ron Paul is a crank who likes woo-woo medical practices despite being a doctor.Schiff predicted eight of the last two crashes.Both believe in a now disproven philosophy that self regulated entities "know best" - hows that GFC and the Gulf oil spill working out for you?